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CHAPTER 4: CONSUMER CHOICE

1. CONSUMER CHOICE
Microeconomics provides powerful insights into the myriad questions and choices
facing consumers. To answer questions about individual decision making, we need
a model of individual behaviour. Our model of consumer behaviour is based on the
following premises:
 Individual tastes or preferences determine the amount of pleasure people
derive from the goods and services they consume.
 Consumers face constraints or limits on their choices.
 Consumers maximize their well-being or pleasure from consumption, subject
to the constraints they face.

In economic analyses designed to explain behaviour economists assume that

consumers have a set of tastes or preferences that they use to guide them in choosing
between goods.

Goods are ranked according to how much pleasure a consumer gets from
consuming each. Preference relations summarize a consumer’s ranking:

 > is used to convey strict preference.

 ≥ is used to convey weak preference.
 < is used to convey indifference.
1.1 Properties of Consumer Preferences
We make three assumptions about the properties of consumers’ preferences. For
brevity, we refer to these properties as completeness, transitivity, and more is
better.
 Completeness → The completeness property holds that, when facing a
choice between any two bundles of goods, Bundles a and b, a consumer
can rank them so that one and only one of the following relationships is
true: a>b, b>a or both relationships a~b. This property rules out the
possibility that the consumer cannot decide which bundle is
preferable.
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 Transitivity → Consumers’ rankings are logically consistent in the sense

that if a>b and b>c, then a >c.
 More is better → The more-is-better property states that, all else the
same, more of a commodity is better than less of it.
o Good: a commodity for which more is preferred to less, at least at
some levels of consumption.
o Bad: something for which less is preferred to more, such as
pollution
1.2 Preference Maps
Surprisingly enough, with just these three properties, we can tell a lot about a
consumer’s preferences. One of the simplest ways to summarize information
about a consumer’s preferences is to create a graphical interpretation -a map-of
them.
 Indifference curve: the set of all bundles of goods that a consumer
views as being equally desirable.
 Indifference map: a complete set of indifference curves that summarize
a consumer’s tastes or preferences.

We assume that indifference curves are continuous-have no gaps-as the figure shows.
The indifference curves are parallel in the figure, but they need not be. We can
demonstrate that all indifference curve maps must have the following four properties:

1. Bundles on indifference curves farther from the origin are preferred to those on
indifference curves closer to the origin.
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2. An indifference curve goes through every possible bundle.

3. Indifference curves cannot cross.
4. Indifference curves slope downward.

1.3 Impossible indifference curves

1.4 Willingness to Substitute Between Goods

 Marginal rate of substitution (MRS): the maximum amount of one
good a consumer will sacrifice to obtain one more unit of another good.
The marginal rate of substitution refers to the trade-off (rate of
substitution) of burritos for a marginal (small additional or incremental)
change in the number of pizzas.

¡OJO! The MRS between two points is the same as the slope of the
indifference curve between those tow points.
 Curvatures:
o Convex to the origin: casual observations suggest that most
people’s indifference curves are convex to the origin.
o Concave to the origin
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o Lineal

Extreme cases:

- perfect substitutes: goods that a consumer is completely

indifferent as to which to consume. Because Bill cannot
taste any difference between Coca-Cola and Pepsi-Cola,
he views them as perfect substitutes: He is indifferent
between one additional can of Coke and one additional
can of Pepsi. His indifference curves for these two goods
are straight, parallel lines with a slope of everywhere
along the curve.
- Perfect complements: goods that a consumer is
interested in consuming only in fixed proportions.
Maureen doesn’t like pie by itself or ice cream by itself
but loves pie à la mode: a slice of pie with a scoop of
vanilla ice cream on top.

1.5 Diminishing Marginal Rate of Substitution

 The marginal rate of substitution approaches zero as we move down and
to the right along an indifference curve.
 Consumers generally prefer a balanced market basket.
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2. UTILITY
 Economists apply the term utility to this set of numerical values that
reflect the relative rankings of various bundles of goods.
 Utility function is defined as the relationship between utility measures
and every possible bundle of goods.

*U: en el nombre del punto a estudiar

*Z y B: el número de pizzas y de burritos
The utility function is a concept that economists use to help them think about consumer
behavior; utility functions do not exist in any fundamental sense. So, that’s why
consumer’s rank-ordering exist.
2.1 Ordinal preferences
If we only know a consumer’s relative ranking of bundles, the measure of pleasure is
ordinal. It tells us the relative ranking of two things but not how much more one rank
is than another (self-rated health).
A cardinal measure is one by which absolute comparisons between ranks may be made
(money).
2.2 Utility and indifference Curves
An indifference curve consists of all those bundles that correspond to a particular level
of utility, say U. If Lisa’s utility function is U (Z, B), then the expression for one of her
indifference curves is:

2.3 Marginal Utility

The marginal utility is the extra utility that a consumer gets from consuming the last
unit of a good. The slope of the utility function as we hold the quantity of the other
good constant.
Marginal utility of good Z is:
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2.4 Utility and Marginal Utility

 As Lisa consumes more pizza, holding her consumption of burritos constant at

10, her total utility, U, increases…and her marginal utility of pizza, MUZ,
decreases (though it remains positive).
 Marginal utility is the slope of the utility function as we hold the quantity of the
other good constant.
2.5 Utility and Marginal Rates of Substitution
The Marginal Rate of Substitution is the negative of the ratio of the marginal utility of
another pizza to the marginal utility of another burrito.

→ ¡OJO! The formula is like this because as consumption moves along an indifference
curve, U is fixed at Ū and additional utility from an increase in burritos (B), must equal
the loss of utility from the decrease in pizzas (Z).
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3. BUDGET CONSTRAINT
 Budget line (or budget constraint) - the bundles of goods that can be bought if
the entire budget is spent on those goods at given prices.

 Opportunity set - all the bundles a consumer can buy, including all the bundles
inside the budget constraint and on the budget constraint.
Knowing an individual’s preferences is only the first step in analyzing that persons
consumption behavior. Consumers maximize their well-being subject to constraints. The
most important constraint most of us face in deciding what to consume is our personal
budget constraint.
If we cannot save and borrow, our budget is the income we receive in a given period. If
we can save and borrow, we can save money early in life to consume later, such as when
we retire; or we can borrow money when we are young and repay those sums later in
life. Savings is, in effect, a good that consumers can buy. For simplicity, we assume that
each consumer has a fixed amount of money to spend now, so we can use the terms
budget and income interchangeably.
For graphical simplicity, we assume that consumers spend their money on only two
goods. If Lisa spends all her budget, Y, on pizza and burritos, then:
pBB + pZZ = Y,
 where pBB is the amount, she spends on burritos and pZZ is the amount she
spends on pizzas.
 This equation is her budget constraint. It shows that her expenditures on
burritos and pizza use up her entire budget.
If we want to know how many units of a good we can buy, for example burritos, we use
this equation:

The red part is the slope of the Budget Constraint, which is also called the Marginal
Rate of Transformation (MRT) and it is ▲B/▲Z.
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We can buy more units of a good because of one of these reasons:

1. With higher income
2. A lower price of one of those goods we want to choose
3. Buying fewer units of one good
3.1Effect of a Change in Price on the Opportunity Set
If the price of pizza doubles but the price of burritos is unchanged, the budget
constraint swings in toward the origin in panel a of Figure 4.8. If Lisa spends all her
money on burritos, she can buy as many burritos as before, so the budget line still hits
the burrito axis at 25. If she spends all her money on pizza, however, she can now buy
only half as many pizzas as before, so the budget line intercepts the pizza axis at 25
instead of at 50.
Unless Lisa only wants to eat burritos, she is unambiguously worse off due to this
increase in the price of pizza because she can no longer afford the combinations of pizza
and burritos in the shaded “Loss” area.
A decrease in the price of pizza would have the opposite effect: The budget line
would rotate outward around the intercept of the line and the burrito axis. As a result,
the opportunity set would increase.

Slope= $-2/$2=-1 This area represents the bundles she can longer afford
3.2 Constrain Consumer Choice
Given information on Lisa’s preferences and how much she can spend, we can
determine her optimal bundle. Her optimal bundle is the bundle out of all the bundles
that she can afford that gives her most pleasure. In fact, the optimal bundle must lie on
the budget constraint.
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Moreover, in e the budget constraint and the indifference curve have the same slope
where they touch. Therefore, at point e:

 When consumers maximize satisfaction → MRS=-MUz/MUb= -Pz/Pb →

MUb/Pb=MUz/Pz
Total utility is maximized when the budget allocated so that the marginal utility
per dollar of expenditure is the same for each good.
3.3 Some special cases
A corner solution exists if a consumer buys in extremes and buys all of one category of
a good and none of another. In fact, MRS is not necessarily equal to -Pz/Pb
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3.4 Examples of utility Function

 Complements:
o U(x,y)=min {ax,by} with a,b>0
o Multiplying by a constant is a monotonic transformation
o Example: min {2x,y}
 Subtitutes:
o U(x,y)=ax+by with a, b > 0
o Example: 2x+y (Indifferent between 1 unit of x and 2 units of y)
 Quasi-linear:
o U(x,y)=ax+u(y) with a>0
o Example: U= x+ ln(y)
3.5 Curvature of Indifference Curves
MRS diminishes along many typical indifference curves that are concave to the origin.
However, different utility functions generate different indifference curves.

 Perfect Subtitutes:
o Goods that a consumer is completely indifferent between
o For example: Clorox (C) and Generic Bleach (G) U(C,G)= iC+ jG
o MRS = -MUC/MUG = −i/j (constant)
 Perfect complements:
o Goods that are consumed in fixed proportions
o For example: Apple pie (A) and Ice cream (I) U(A,V)=min(iA, jV)
o MRS is undefined
 Imperfect Substitutes
o Between extreme examples of perfect substitutes and perfect
complements are standard-shaped, convex indifference curves.
o Cobb-Douglas utility function indifference curves
never hit the axes.
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o Quasilinear utility function U(q1,q2)=u(q1)+q2 indifference curves hit

one of the axes.

3.6 Ways to Solve Contrained max problem:

 Method 1: Lagrange Multiplier
 Method 2: By substitution
 Method 3: MRS=MRT
These methods all work well for Cobb-Douglas, but not for perfect substitutes,
complements and only sometimes for quasi-linear.
For quasi-linear there are times that MRS<MRT → Corner solution
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SUMMARY UNIT 4
Consumers maximize their utility (well-being) subject to constraints based on their
income and the prices of goods.
1. Preferences: To predict consumers’ responses to changes in constraints,
economists use a theory about individuals’ preferences. One way of
summarizing consumers’ preferences is with a family of indifference curves. An
indifference curve consists of all bundles of goods that give the consumer a
particular level of utility. Based on observations of consumers’ behavior,
economists assume that consumers’ preferences have three properties:
completeness, transitivity, and more is better. Given these three assumptions,
indifference curves have the following properties:
a. Consumers get more pleasure from bundles on indifference curves the
farther from the origin the curves are.
b. An indifference curve goes through any given bundle.
c. Indifference curves cannot cross.
d. Indifference curves slope downward.
e. Indifference curves are thin.

2. Utility: Economists call the set of numerical values that reflect the relative
rankings of bundles of goods utility. Utility is an ordinal measure: By comparing
the utility a consumer gets from each of two bundles, we know that the
consumer prefers the bundle with the higher utility, but we can’t tell by how
much the consumer prefers that bundle. The marginal utility from a good is the
extra utility a person gets from consuming one more unit of that good, holding
the consumption of all other goods constant. The rate at which a consumer is
willing to substitute Good 1 for Good 2, the marginal rate of substitution, MRS,
depends on the relative amounts of marginal utility the consumer gets from each
of the two goods.
3. Budget Constraint: The number of goods consumers can buy at given prices is
limited by their income. As a result, the greater their income and the lower the
prices of goods, the better off they are. The rate at which they can exchange
Good 1 for Good 2 in the market, the marginal rate of transformation,
MRT,depends on the relative prices of the two goods.
4. Constrained Consumer Choice: Each person picks an affordable bundle of
goods to consume so as to maximize his or her pleasure. If an individual
consumes both Good 1 and Good 2 (an interior solution), the individual’s utility
is maximized when the following four equivalent conditions hold:
a. The indifference curve between the two goods is tangent to the budget
constrain.
b. The consumer buys the bundle of goods that is on the highest obtainable
indifference curve. The consumer’s marginal rate of substitution (the
slope of the indifference curve) equals the marginal rate of
transformation (the slope of the budget line).
c. The last dollar spent on Good 1 gives the consumer as much extra utility
as the last dollar spent on Good 2.
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However, consumers do not buy some of all possible goods (corner

solutions). The last dollar spent on a good that is purchased gives more extra
utility than would a dollar’s worth of a good the consumer chose not to buy.
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CHAPTER 5: APPLYING CONSUMER

THEORY
1. DERIVING DEMAND CURVES
By varying one price and holding other prices and income constant, we
determine how the quantity demanded changes as the price changes, which is the
information we need to draw the demand curve. After deriving an individual’s
demand curve, we show the relationship between consumer tastes and the shape
of the demand curve, which is summarized by the elasticity of demand.

 Según la ley de la demanda: la demanda de un bien disminuye al

aumentar el precio del bien en cuestión. No obstante, hay otras variables
que influyen sobre la demanda:
 Bienes sustitutivos: el aumento del precio de un bien lleva a una
reducción de la demanda del propio bien y a un aumento de la demanda
de su sustitutivo.
 Bienes complementarios: si aumenta el precio de un bien, su cantidad
demanda disminuiría y, por tanto, sería menor la cantidad demandada del
bien complementario.
 Bienes independientes: la variación del precio de uno de ellos no
afectaría a la cantidad demandada del otro.
 La renta: depende de si los bienes son:
o Bienes normales: su demanda aumenta al aumentar la renta o los
ingresos.
o Bienes inferiores: su cantidad demandada disminuye al aumentar
la renta.
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1.1. Price-Consumption Curve

It is a line through the optimal bundles at each price of one good when the price of the
other good and the budget are held constant.

The demand curve corresponds to the price- consumption curve.

 Demand curve on a Price/Quantity graph

 Price consumption on a Quantity/Quantity graph
1.2 Effect of a Rise in Income
 Engel Curve: the relationship between the quantity demanded of a single good
and income, holding prices constant.
o Bien normal: pendiente positiva
o Bien inferior: pendiente negativa
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 Income-consumption curve: Income-consumption curve shows how

consumption of both goods changes when income changes, while prices are held
constant.

2. CONSUMER THEORY AND INCOME ESLASTICITIES

Income elasticities tell us how much the quantity demanded changes as income
increases. We can use income elasticities to summarize the shape of the Engel curve, the
shape of the income-consumption curve, or the movement of the demand curves when
income increases.
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 Example: If a 1% increase in income results in a 3% increase in quantity

demanded, the income elasticity of demand is x = 3%/1% = 3.

2.1 Consumer Theory and Income Elasticities

Normal Good Positive income elasticity

Luxury goods Income elasticity greater than 1
Necessity goods Income elasticity between 0 and 1
Inferior goods Negative income elasticity

IMPORTANT:

 The income elasticities depend on where on the new budget constraint the new
optimal consumption bundle will be.
 If the quantity of a good decreases with a rise in income this is an inferior good.
 If the quantity of a good increases with a rise in income this is a normal good.

3. EFFECTS OF A PRICE CHANGE

A change in the price has two effects:
 Substitution Effect
 Income Effect

3.1 Subtitution Effect

The substitution effect is the change in an item’s consumption associated with a
change in the price of the item, with the level of utility held constant. Consumers
will tend to buy more of the good hat has become relatively cheaper, and less of the
good that is relatively more expensive. When the price of an item increases, the
substitution effect always leads to a decrease in the quantity demanded of the good.
For example: when housing gets more expensive relative price of housing to food
goes up, and with less housing more food that keeps you happy.
3.2 Income Effect
The income effect is the change in an item’s consumption brought about by the
decrease in purchasing power, with the price of the item held constant. When a
person’s income decreases, the quantity demanded for the product may increase or
decrease, because higher prices reduce opportunity set.
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3.3 Income and Substitution Effects with an Inferior Good

 Inferior Good: the income effect and the substitution effect move in
opposite directions. For most inferior goods, the income effect is smaller
than the substitution effect.
 Giffen Good: f the income effect more than offsets the substitution effect,
we have a Giffen good, for which a decrease in its price causes the quantity
demanded to fall.

4. INFLATION INDEXES
 Inflation: the increase in the overall price level over time.
o Nominal price: the actual price of a good
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o Real price: the price adjusted for inflation.

4.1 How do we adjust for inflation to calculate the real price?
 Consumer Price Index: measure the cost of a standard bundle of goods for
use in comparing prices over time.
 Cost-of-living Adjustment: If a person’s income increases automatically
with the CPI, he can afford to buy the first year’s bundle in the second year
but chooses not to. Better off in the second year because the CPI- based
COLA overcompensates in the sense that utility increases.
 True cost-of-living index: an inflation index that holds utility constant over
time.
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SUMMARY: